Reexamining 'All Substantial Rights' and Prior Non-Exclusive Licenses

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By Harsha Reddy, Esq.
Pillsbury Winthrop Shaw Pittman LLP , New York, NY

The phrase "all substantial rights" is a touchstone concept in the U.S. federal income taxation of intellectual property, implicating, or argued by the Service to implicate, among other things, whether a transfer of a trade secret or know-how constitutes a sale or exchange, whether a transfer of a computer software copyright right is a sale or exchange for purposes of certain provisions of the Code, whether a contribution of intellectual property to a corporation or partnership is a non-recognition event, and a taxpayer's entitlement to the §41 credit for funded research.1

Perhaps most famously, pursuant to §1235(a), a "holder" who transfers all "substantial rights" to a patent is entitled to long–term capital gain treatment regardless of his holding period, the method of payment, or his status as a professional inventor.2 In addition, there is an exemption from the Code's imputed interest rules for contingent payments in a §1235(a) sale.3 Only individuals may be holders.4 Regulations specify grants of rights to a patent that will not be considered all substantial rights to the patent,5 examples of rights which are not considered substantial,6 examples of rights which may or may not be substantial,7 and that the right to terminate at will is always a substantial right.8

The Senate Report accompanying the enactment of §1235 specifically provided that existing law was to be applied to sales of patents not within its scope, such as sales by individuals who do not qualify as holders or by corporations.9 After the enactment of §1235, case law and rulings concerning assignments or licenses outside the scope of §1235(a) generally also focus on whether "all substantial rights" to the patent have been transferred; however, the meaning of the phrase is not the same.

For example, it is relatively well-settled that a transfer of patent, which is subject to a prior, non-exclusive license, is generally not a transfer of all substantial rights within the meaning of §1235(a).10 A district court decision held the same in a non-§1235 case.11 However, in MacDonald v. Comr.,12 the Tax Court held that a corporation's assignment of a patent, which it acquired subject to a prior non-exclusive license, was entitled to long-term capital gain treatment under §1221 or §1231.13 In Rev. Rul. 78-328,14 the IRS ruled that a corporation which sold its rights to a patent, which was subject to a nonexclusive, royalty-free license granted by its predecessor transferor, was entitled to long-term capital gain treatment under §1231.15 In addition, the IRS explained that its acquiescence in MacDonald "merely" indicated its agreement with the court's holding that the assignment in that case qualified for long-term capital gain treatment and not that the regulations under §1235 are not controlling for purposes of §1235.

If a taxpayer is unable to fall within the bounds of Rev. Rul. 78-328, i.e., if the taxpayer itself previously granted a prior, non-exclusive license, is the taxpayer forever after barred from long-term capital gain treatment? If the taxpayer is able to cancel the license, or re-acquire exclusive rights, prior to or contemporaneously with the subsequent assignment or license, then the taxpayer should not be. Under long-standing case law that the facts and circumstances of the entire transaction are considered in determining whether a transfer of all substantial rights has taken place as well as the step transaction doctrine, the result should be the same if the cancellation occurs shortly after, and is required by, the transfer agreement.  Similarly, long-term capital gain treatment should be available if the previously issued license is scheduled to terminate by its terms shortly after the transfer (and the transferee has the right to approve any extension).16 If the taxpayer is unable to cancel the previously granted license but the license is limited to a field of use that has no commercial value at the time of the subsequent transfer, then even §1235(a) treatment may be available.17 What about the case where the taxpayer is unable to cancel and the license is not limited to a field of use with no commercial value?

In Graham v. Comr.,18 the taxpayer and an unrelated individual (Matthews) each had a 50% interest in a patent with respect to ventilated awnings. They subsequently granted a corporation in which they together with members of their immediate family and two unrelated individuals were shareholders a right to license others to make, use, and sell products under the patent throughout the United States (except for certain states which were covered by exclusive licenses to make, use, and sell previously granted by the taxpayer and Matthews to two unrelated persons)19 and to collect royalties from the licensees.  The license did not grant the corporation itself the right to make, use, and sell. Four years later, the taxpayer, Matthews and the corporation entered into a new agreement, which cancelled and superseded their previous agreement. The new agreement transferred the patent to the corporation in addition to the aforementioned previously granted exclusive licenses. In the event that those licenses were to become null and void, terminated, or otherwise expired, the corporation would have the exclusive right to make, use and sell in the states covered by those licenses. As noted by the Tax Court, the assignment of the patent to the corporation was subject to any licenses previously granted by the corporation. The Tax Court held that the amounts received by the taxpayer from the corporation were long-term capital gain.

Graham stands for at least two propositions relevant here. First, a previously granted non-exclusive license should not necessarily defeat sale treatment in a transaction outside the scope of §1235(a). Second, it is helpful if the transferee becomes the owner of the previously granted license (or was already the licensee or licensor of the previously granted license).  These propositions are informed by a rich body of law, including the legislative history to §1235, which instructs that all the facts and circumstances must be examined for purposes of determining whether a transfer of a patent constitutes a sale for U.S. federal income tax purposes.

 For more information, in the Tax Management Portfolios, see Falk, 557 T.M., Tax Planning for the Development and Licensing of Patens and Know-How,  and in Tax Practice Series, see ¶1720, Transfers of Patents, Know-How, Franchises, Trademarks and Trade Names.


Copyright©2009 by The Bureau of National Affairs, Inc.

  1 All references to "section," "§" and "Regs. §" are to the Internal Revenue Code of 1986, as amended, (the "Code") and the regulations thereunder, as applicable, unless otherwise stated.


  2 Different rules apply in the case of non-resident aliens. See Regs. §1.1235-1(f).


  3 See §§1274(c)(3)(E), 483(d)(4).


  4 §1235(b); Regs. §1.1235-2(d).


  5 Regs. §1.1235-2(b)(1).


  6 Regs. §1.1235-2(b)(2).


  7 Regs. §1.1235-2(b)(3).


  8 Regs. §1.1235-2(b)(4).


  9 S. Rep. No. 1622 at 441. At one time, there was an issue as to whether a holder who failed §1235(a) was automatically denied capital gain treatment under other provisions of the Code. See Poole v. Comr., 46 T.C. 392 (1966). However, it is now well-established that a holder who fails §1235 may still qualify for long-term capital gain treatment under other provisions of the Code. See Rev. Rul. 69-482, 1969–2 C.B. 164.


  10 See Regs. §1.1235-2(b)(1), which provides that "the term "all substantial rights to a patent" means all rights (whether or not then held by the grantor) which are of value at the time the rights to the patent (or an undivided interest therein) are transferred" (emphasis added). See alsoBlake v. Comr., 615 F.2d 731 (6th Cir. 1980).


  11 See First National Tr. & Savings Bank of San Diego v. U.S., 200 F. Supp. 274 (1961).


  12 55 T.C. 840 (1971), acq., 1973-1 C.B. 2.


  13 The court in dicta expressed its view to the effect that a taxpayer which previously granted a non-exclusive license may be entitled to treat a subsequent assignment or license of the remaining rights in the patent as a sale. It also disagreed with the Service's argument that the definition of "all substantial rights" in the regulations under §1235 should apply "by analogy" to a transfer outside the scope of §1235 and even questioned the validity of those regulations.


  14 1978-2 C.B. 215.


  15 In Rev. Rul. 88-24, 1988-1 C.B. 306, the IRS reached a similar result as to a franchisee's transfer of a franchise notwithstanding the original franchisor's retention of a significant power, right, or continuing interest (within the meaning of §1253(a)) with respect to the franchise.


  16 The taxpayer should be able to bolster its position by also assigning the right to receive any royalties pending termination, something that the taxpayer in First National Tr. & Savings Bank of San Diego v. U.S., 200 F. Supp. 274 (S.D. Cal. 1961), a non-§1235 case frequently cited for the proposition that a previously granted non-exclusive license necessarily precludes long-term capital gain treatment on a later transfer, failed to do.


  17 See footnote 10, above.


  18 26 T.C. 730 (1956).


  19 There are several non-§1235 cases permitting an assignment or license with a geographical restriction to qualify for sale or exchange treatment. See, e.g., Marco v. Comr., 25 T.C. 544 (1955), nonacq.